Understanding

Financial
System and Its
Purpose
Outline

The Financial Why do we

01 02 03
The Financial System is the The financial system is made These institutions are
collection of institutions that up of financial institutions intermediaries between
facilitate the flow of funds that essentially channel Economic Agents that may be
between savers and users. savings into investment in savers at one time and
financial markets by buying investors at another.
and selling financial products.
 In modern societies, all entities involved in business relationships are called economic agents.
All these agents – the state, households and companies - receive incomes and make
expenditures.

What are 1.
2.
State:
Households:
Makes consumption, investment and economic policy decisions;
Make decisions on consumption of goods and services and on
Economic savings, depending on their income;
3. Companies: Make investment, production and employment decisions.
Agents?
These three agents and financial institutions are part of a closed economy. However, it is
increasingly necessary to consider a fourth agent - outside regions with which the other
economic agents do considerable business in an open economy.
 The Importance of Economic Activity
Societies invented Currency to facilitate economic activity.

• Currency means that a person can sell something without having to receive a specific
good in exchange.

• Currency and payment systems allow people to travel and enable companies to do
business with other companies operating in faraway locations.

• Currency also means that the surplus resources (Savings) of economic agents –
individuals, households and companies - can be channeled to others who need them
(Investment). This operation not only enables people investing their resources to earn
income in the future but also increases investment and entrepreneurship.
Why Financial Market Exists
• The financial system and the banks play a crucial role in
the economy's use of currency.
• Banks run the payment systems that enable local
markets to operate and individuals and companies to
travel to distant places and act there.
• Without a well-structured banking system, currency
would not be able to circulate and it would also be
harder to create markets for goods and services and for
people and goods to circulate.
• Banks are also essential as financial intermediaries. In
other words, they take the savings of people with
surplus resources and make them available to others
who need them. Without this operation, people's and
companies' ability to invest would be very limited.
 The Financial System: Saving
• When economic agents earn income, they are first required to make
compulsory contributions (Tax and Social Security). The income left over
after these contributions have been paid is called Disposable Income (DI).
• Typically, economic agents don’t want to consume their entire disposable
income all at once.
• If the state, households and companies do not spend their entire
disposable income, the unconsumed income is called Saving.
 The Financial System: Investment
• On the other hand, there are people who may wish to spend money on
various potentially valuable projects but either have no money of their
own or may wish to spend their personal funds on projects other than
their own.
• The money that these people need for their spending plans is called
investment
The Financial System Makes Saving Equal
Investment
• The financial system makes it easier for lenders (those who have the
saving funds) and borrowers (those who need funds for investment)
to find each other.
• Both groups benefit when the financial system does its job well
• When the financial system fails, both groups suffer.
What does the financial system do?
• The financial system serves multiple purposes:
• It helps entrepreneurs find the money needed to turn business ideas into
reality
• It helps entrepreneurs pursue business projects without having to personally
carry too much of the risks associated with their projects
• It helps to protect lenders from irresponsible borrowers
• It helps to foster economic growth by channeling savings to the most valuable
projects and cutting off funds for the less valuable projects
Financing Investment
• The financial system helps entrepreneurs find the money needed to
turn business ideas into reality
• The money may take the form of
• Debt finance (the entrepreneur sells bonds to raise money), and
• Equity finance (the entrepreneur sells stocks to raise money)
Financing Investment
• The flow of funds takes place through
• Financial markets
• Stock market, bond market
• Financial intermediaries
• Banks, mutual funds, pension funds, insurance companies
What does the financial system do?
• The financial system serves multiple purposes:
• It helps entrepreneurs find the money needed to turn business ideas into
reality
• It helps entrepreneurs pursue business projects without having to personally
carry too much of the risks associated with their projects
• It helps to protect lenders from irresponsible borrowers
• It helps to foster economic growth by channeling savings to the most valuable
projects and cutting off funds for the less valuable projects
Sharing Risk
• The financial system helps entrepreneurs pursue business projects
without having to personally carry too much of the risks associated
with their projects
• The financial system also enables savers to diversify—that is, lend
their money to a variety of borrowers—thereby reducing the risks of
lending
Sharing Risk
• Suppose it is your dream to start a restaurant.
• Even if you have enough savings of your own to pay for the
restaurant, it might still be better to share the risks—and the rewards
—of the restaurant venture with others
• And others may wish to share the risks of your restaurant venture if
they believe that the returns would be good
Sharing Risk
• The financial system—that is, the financial markets and financial
intermediaries—may put you in touch with other investors
• They would provide you money to get your restaurant started in
return for part ownership
• This is equity finance
• This way you would not have to carry the full risk of your restaurant
on your own shoulders
Sharing Risk
• Even if you are not an entrepreneur, the financial system can help you
use your savings to acquire ownership of a diversified portfolio of
business enterprises.
• This will help you keep your idiosyncratic risks low.
• But systemic risks may remain.
What does the financial system do?
• The financial system serves multiple purposes:
• It helps entrepreneurs find the money needed to turn business ideas into
reality
• It helps entrepreneurs pursue business projects without having to personally
carry too much of the risks associated with their projects
• It helps to protect lenders from irresponsible borrowers
• It helps to foster economic growth by channeling savings to the most valuable
projects and cutting off funds for the less valuable projects
Dealing With Asymmetric Information
• Borrowers can hide crucial information—about their abilities and
their plans—from potential lenders
• As a result, unsuspecting lenders can get ripped off
• If that happens often enough, all lending would eventually end and
the financial system would be unable to do what it is supposed to do.
Dealing With Asymmetric Information
• The financial system—especially financial intermediaries, such as
banks, and watchdogs, such as government regulators and the courts
—can help lenders by
• ensuring that lenders get adequate information about potential borrowers
• keeping a watchful eye on borrowers to ensure that they do nothing stupid or
reckless with borrowed money
• punishing dishonest treatment of lenders
Dealing With Asymmetric Information
• When entrepreneurs hide information about themselves or the
projects for which they are seeking money, lenders face the problem
of adverse selection
• When entrepreneurs hide information about how hard they intend to
work to make their projects successful, lenders face the problem of
moral hazard
Dealing With Asymmetric Information
• Why would an entrepreneur borrow money for his/her project?
• has no personal funds
• has enough personal funds, but wants to diversify risks
• knows something negative about the project that he/she is hiding from
lenders (adverse selection)
• has no intention to work hard for the project (moral hazard)
Dealing With Asymmetric Information
• A lender can partially avoid the problems of adverse selection and
moral hazard by lending money to an intermediary, such as a bank,
and letting the bank deal with the borrower
• The bank may have the resources to dig up hidden information about
the borrower and the project
• The bank may be able to ensure that the borrower will work hard to
make the project a success
Dealing With Asymmetric Information
• In some cases, asymmetric information may hurt an honest borrower
• An entrepreneur may be honest and hard working, but may be unable
to convince potential lenders that she is honest and hard working
• Here too, bank finance may be the solution
• A bank may be willing to lend money to this borrower because the
bank has resources to monitor the borrower, who in this case
happens to be genuinely hard working
Dealing With Asymmetric Information
• Government regulators and the law enforcement system have
obviously important roles to play in dealing with adverse selection
and moral hazard.
What does the financial system do?
• The financial system serves multiple purposes:
• It helps entrepreneurs find the money needed to turn business ideas into
reality
• It helps entrepreneurs pursue business projects without having to personally
carry too much of the risks associated with their projects
• It helps to protect lenders from irresponsible borrowers
• It helps to foster economic growth by channeling savings to the most valuable
projects and cutting off funds for the less valuable projects
Fostering Economic Growth
• The financial system helps to foster economic growth by channeling
savings to the most valuable projects and cutting off funds for the less
valuable projects
• When asymmetric information is not a problem, a market for loanable
funds in which people are free to lend and borrow should ensure the
success of economically valuable projects and the failure of
economically wasteful projects
Fostering Economic Growth
• For example, if in a well-functioning loanable funds market the
equilibrium interest rate is 4%, then
• the projects that can earn profits higher than 4% will succeed, and
• the projects that cannot do so will fail
• It cannot be that a less profitable project gets funded and a more profitable
project does not
• In this way, a free market will automatically allocate funds so as to
foster economic growth